1. © 2007 Pearson Addison-Wesley. All rights reserved Lecture 11 The Political Economy of Trade Policy

2. 10-2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Preview The cases for free trade The cases against free trade Political models of trade policy International negotiations of trade policy and the World Trade Organization

3. 10-3 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases for Free Trade The first case for free trade is the argument that producers and consumers allocate resources most efficiently when governments do not distort market prices through trade policy. –National welfare of a small country is highest with free trade. –With restricted trade, consumers pay higher prices. –With restricted trade, distorted prices cause overproduction either by existing firms producing more or by more firms entering the industry.

4. 10-4 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases for Free Trade (cont.)

5. 10-5 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases for Free Trade (cont.) However, because tariff rates are already low for most countries, estimated benefits of moving to free trade are only a small fraction of national income for most countries.

6. 10-6 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases for Free Trade (cont.)

7. 10-7 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Tariff Revenue

8. 10-8 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases for Free Trade (cont.) Yet for some countries in some time periods, the estimated cost of protection was substantial.

9. 10-9 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases for Free Trade (cont.)

10. 10-10 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases for Free Trade (cont.) A second argument for free trade is that allows firms or industry to take advantage of economies of scale. Krugman’s IRS A third argument for free trade is that it provides competition and opportunities for innovation. These dynamic benefits would not be reflected in static estimates of the elimination of efficiency losses of producers, caused by distorted prices and overproduction.

11. 10-11 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases for Free Trade (cont.) A fourth argument, called the political argument for free trade, says that free trade is the best feasible political policy, even though there may be better policies in principle. –Any policy that deviates from free trade would be quickly manipulated by special interests, leading to decreased national welfare.

12. 10-12 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade For a “large” country, a tariff or quota lowers the price of imports in world markets and generates a terms of trade gain. –This benefit may exceed production and consumption distortions. In fact, a small tariff will lead to an increase in national welfare for a large country. –But at some tariff rate, the national welfare will begin to decrease as the economic efficiency loss exceeds the terms of trade gain.

13. 10-13 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.6 Domestic Welfare Depends on the Tariff Rate

14. 10-14 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade (cont.)

15. 10-15 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade (cont.) Last Figure: a tariff rate that completely prohibits trade (tp) leaves the country worse off than with free trade. Further increases in the tariff rate beyond tp have no effect, so the curve flattens out. A tariff rate that completely prohibits imports leaves a country worse off, but tariff rate t 0 may exist that maximizes national welfare: an optimum tariff.

16. 10-16 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade (cont.) An export tax (a negative export subsidy) that completely prohibits exports leaves a country worse off, but an export tax rate may exist that maximizes national welfare through the terms of trade. –An export subsidy lowers the terms of trade for a large country; an export tax raises the terms of trade for a large country. –An export tax may raise the price of exports in the world market, increasing the terms of trade.

17. 10-17 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Argument against Free-Trade For some countries like the US an import tariff or /and export tax could improve national welfare at the expense of other countries. But this argument ignores the likelihood that other countries may retaliate against large countries by enacting their own trade restrictions.

18. 10-18 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade (cont.) A second argument against free trade is that domestic market failures may exist that cause free trade to be a suboptimal policy. –The economic efficiency loss calculations using consumer and producer surplus assume that markets are functioning efficiently.

19. 10-19 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade (cont.) Types of market failures include –Persistently high under-employment of labor –Persistently high under-utilization of capital –Technological benefits for society from additional production that are not captured by individual firms –Environmental costs for society from additional production that are not paid for by individual firms

20. 10-20 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade (cont.) Economists calculate the marginal social benefit to represent the additional benefit to society from additional production. –In each of the market failure cases, marginal social benefit is not accurately measured by the producer surplus of private firms, so that economic efficiency loss calculations are misleading. It is possible that a tariff raises domestic production, thereby increasing the benefit to domestic society because of a market failure.

21. 10-21 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade (cont.)

22. 10-22 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Cases Against Free Trade (cont.) The domestic market failure argument against free trade is an example of a more general argument called the theory of the second best. This theory states that government intervention which distorts market incentives in one market may increase national welfare by offsetting the consequences of market failures elsewhere. –The best policy would be to fix the market failures themselves, but if this is not feasible, then government intervention in another market may the “second-best” way of fixing the problem.

23. 10-23 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Counter-Arguments Economist supporting free trade counter- argue that domestic market failures should be corrected by a “first-best” policy: a domestic policy aimed directly at the source of the problem. –If persistently high under-employment of labor is a problem, then the cost of labor or production of labor- intensive products could be subsidized by the government. –These subsidies could avoid the economic efficiency loss for consumers due to a tariff.

24. 10-24 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Counter-Arguments (cont.) Because it is unclear when and to what degree a market failure exists in the real world, it is unclear when and to what degree government policies should respond. Government policies to address market failures are likely to be manipulated by politically powerful groups. Because it distorts the incentives of producers and consumers, a trade policy may have unintended consequences that make a situation worse, not better.

25. 10-25 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Political Models of Trade Policy How is trade policy determined? Models that address this question: 1.Median voter theorem 2.Collective action 3.A model of trade policy that combines aspects of collective action and the median voter theorem

26. 10-26 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Median Voter Theorem The median voter theorem predicts that democratic political parties may change their policies to court the voter in the middle of the ideological spectrum (i.e., the median voter). Suppose that this ideological spectrum is defined only by a tariff rate policy. –And suppose that voters can be ranked according to whether they desire high or low tariff rates.

27. 10-27 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Median Voter Theorem (cont.) Assumptions of the model: 1.There are two competing political parties. 2.The objective of each party is to get elected by majority vote (not to maintain ideological purity). What policies will the parties promise to follow? –Both parties will offer the same tariff policy to court the median voter (the voter in the middle of the spectrum) in order to capture the most votes on either side of the median voter.

28. 10-28 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Median Voter Theorem (cont.)

29. 10-29 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Median Voter Theorem (cont.) Thus, the median voter theorem implies that a two- party democracy should enact trade policy based on how many voters it pleases. –A policy that inflicts large losses on a few people (import- competing producers) but benefits a large number of people (consumers) should be enacted into law. But trade policy doesn’t seem to follow this prediction.

30. 10-30 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Collective Action Political activity is often described as a collective action problem: –While consumers as a group have an incentive to advocate free trade, each individual consumer has no incentive because his benefit is not large compared to the cost and time required to advocate free trade. –Policies that impose large losses in for society as a whole but small losses on each individual may therefore not face strong opposition.

31. 10-31 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Collective Action (cont.) However, for those groups who may suffer large losses from free trade (for example, unemployment), each individual in that group has a strong incentive to advocate the policy he desires. –In this case, the cost and time required to advocate restricted trade is small compared to the cost of unemployment.

32. 10-32 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. A Model of Trade Policy While politicians may win elections partly because they advocate popular policies as implied by the median voter theorem, they also require funds to run campaigns. These funds may especially come from groups who do not have a collective action problem and are willing to advocate a special interest policy. Models of policy making try to measure the trade off between reduction of overall welfare of constituents in return for additional campaign contributions.

33. © 2007 Pearson Addison-Wesley. All rights reserved GATT/WTO

34. 10-34 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Which Industries Are Protected? Agriculture: in the US, Europe and Japan farmers make up a small fraction of the electorate but receive generous subsidies and trade protection. –Examples: European Union’s Common Agricultural Policy, Japan’s 1000% tariff on imported rice, America’s sugar quota.

35. 10-35 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Which Industries Are Protected? (cont.) Clothing: textiles (fabrication of cloth) and apparel (assembly of cloth into clothing). –Import licenses for textile and apparel exporters are specified in the Multi-Fiber Agreement between the US and many other nations. –MFA: U.S. assigned import licenses to exporting countries. –Hence, most of the welfare cost came not from the distortion of consumption and production but from the transfer of quota rents to foreigners.

36. 10-36 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Why Agricultural Protection so Notorious? Special characters : –Protection happens in rich countries but not in poor ones. –It is hard to phase out. Economic Rationale –The inelastic supply of agricultural goods. –Peasants and the district congressional election – The minority is easy to form a group to lobby the government. –The majority has severe “free-rider” problem. Different Patterns: – Import restriction: Japan, Korea, and China –Export subsidy: US, CA, EU (supporting price )

37. 10-37 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Which Industries Are Protected? (cont.)

38. 10-38 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. International Negotiations of Trade Policy The average US tariff rate on dutiable imports has decreased substantially from 1920–1993. Smoot-Hawley Act deepens the Great Depression. Bilateral trade negotiations helped reduce the average duty on U.S. imports from 59% in 1932 to 25% shortly after WWII. Since 1944, much of the reduction in tariffs and other trade restrictions came about through international negotiations. –The General Agreement of Tariffs and Trade was begun in 1947 as a provisional international agreement and was replaced by a more formal international institution called the World Trade Organization in 1995.

39. 10-39 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. International Negotiations of Trade Policy (cont.)

40. 10-40 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

41. 10-41 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. International Negotiations of Trade Policy (cont.) Multilateral negotiation mobilizes exporters to support free trade if they believe export markets will expand. –This support would be lacking in a unilateral push for free trade. –This support counteracts the support for restricted trade by import-competing groups.

42. 10-42 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. International Negotiations of Trade Policy (cont.) Multilateral negotiations also help avoid a trade war between countries, where each country enacts trade restrictions. If each country has a political interest (due to political pressure) to protect domestic producers, regardless of what other countries do, –then all countries could enact trade restrictions, even if it is in the interest of all countries to have free trade. Let’s use a simple example to illustrate this point.

43. 10-43 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. International Negotiations of Trade Policy (cont.)

44. 10-44 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. International Negotiations of Trade Policy (cont.) In this simple example, each country acting individually would be better off with protection, but both would be better off if both chose free trade. If Japan and the US can establish a binding agreement to maintain free trade, both can avoid the temptation of protection and both can be made better off.

45. 10-45 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. World Trade Organization The WTO negotiations address trade restrictions in at least 3 ways: 1.Reduction of tariff rates through multilateral negotiations. 2.Binding: a tariff is “bound” by having the imposing country agree not to raise it in the future.

46. 10-46 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. World Trade Organization (cont.) 3.Prevention of non-tariff barriers: quotas and export subsidies are changed to tariffs because the costs of tariff protection are more apparent. –Subsidies for agricultural exports are an exception. –Exceptions are also allowed for “market disruptions” caused by a surge in imports.

47. 10-47 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. World Trade Organization (cont.) The World Trade Organization was founded in 1995 on a number of agreements –General Agreement on Tariffs and Trade: covers trade in goods –General Agreement on Tariffs and Services: covers trade in services (e.g., insurance, consulting, legal services, banking). –Agreement on Trade-Related Aspects of Intellectual Property: covers international property rights (e.g., patents and copyrights).

48. 10-48 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. World Trade Organization (cont.) –The dispute settlement procedure: a formal procedure where countries in a trade dispute can bring their case to a panel of WTO experts to rule upon. –The cases are settled fairly quickly: even with appeals the procedure is not supposed to last more than 15 months. –The panel uses previous agreements by member countries to decide which ones are breaking their agreements.

49. 10-49 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. World Trade Organization (cont.) –A country that refuses to adhere to the panel’s decision may be punished by allowing other countries to impose trade restrictions on its exports. Example: U.S.—Venezuela –New U.S. air pollution standard makes the imported gasoline producers unhappy. –In 1995, Venezuela argued that the rules violated the principle of “national treatment” –The panel appointed by the WTO ruled in Venezuela’s favor. –U.S. appealed but rejected, therefore, revised its rules.

50. 10-50 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Banana Saga Several small central American nations are “banana republics”. Historically, UK and France purchased banana from their previous western Indian colonies in the Caribbean. Therefore, to protect benefits of such islands’ producers, the EU impose import quota for “dollar banana” of Central America, which are 40% cheaper than the West Indian product. Germany, which has never had West Indian colonies, allowed free entry to dollar bananas. To avoid the arbitrage from Germany to other EU countries, EU tried to impose a new common European import quota against dollar bananas.

51. 10-51 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Banana Saga Germany angrily protested the move and pointed out that its position is warranted in law in the “banana protocol” of Treaty of Rome. Why so angry? A symbol of freedom. In 1995, the U.S. enters the fray by pointing out the quota harms the interest of the U.S. corporation, The Chiquita Banana company. Its CEO walks both sides of the street to lobby politicians. Retaliation from the United States: It imposes high tariffs on designer handbags and pecorino cheese. In 2001, EU phased out the banana import quotas In 2005, EU claimed to triple tariff on banana that do not come from the ACP countries (Africa, Caribbean, and Pacific)

52. 10-52 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Various Rounds of GATT/WTO

53. 10-53 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Various Rounds of GATT/WTO 6 th Kennedy Round (completed in 1967): It reduces tariffs by about 35% 7 th Tokyo Round (1973-1979): It reduces tariffs by a formula more complex than before. In addition, new codes were established in an effort to control the proliferation of NTBs like VERs. 8 th Uruguay Round (1986-1994) Trade liberalization: the average tariff imposed by rich countries will fall almost 40%. Accordingly, tariffs will fall from 6.3% to 3.9%.

54. 10-54 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Uruguay Round (1986-1994) 1. Trade liberalization: the average tariff imposed by rich countries will fall almost 40%. Tariffs will fall from 6.3% to 3.9%. the average tariff imposed by poor countries reduced from 20.5% to 14.4%. 2. Signs the GATS—General Agreements on Trade and Services 3. Signs the TRIPs (initial stage) 4. Form the WTO 5. Reduce some of the NTBs

55. 10-55 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. World Trade Organization (cont.) The GATT/WTO multilateral negotiations ratified in 1994 –agreed that all quantitative restrictions (e.g., quotas) on trade in textiles and clothing as previously specified in the Multi-Fiber Agreement were to be eliminated by 2005. –Agricultural subsidies should be reduced by 36% in value, and 21% in volume over a six-year period. –But as the restrictions were eliminated (mostly in 2005), political pressure to again restrict trade in textiles and clothing has grown.

56. 10-56 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. WTO Non-discrimination Rule: –Most Favored Nation Treatment (MFN): Each country in the WTO promises that all countries will pay tariffs no higher than the nation that pays the lowest. –An exception to this principle is allowed only if the lowest tariff rate is set at zero. –National Treatment: “not worse than the domestic firms” –But could be better. –True in some developing countries for absorbing FDI.

57. 10-57 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. WTO Second principle: Free Trade Third principle: Fair trade 9 th Doha Round (started in 2001): Agriculture, Services, TRIPS (Trade-Related Aspects of Intellectual Properties)

58. 10-58 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Framework

59. 10-59 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Accession

60. 10-60 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Preferential Trading Agreements Preferential trading agreements are trade agreements between countries in which they lower tariffs for each other but not for the rest of the world. Under the WTO, such discriminatory trade policies are generally not allowed: –Each country in the WTO promises that all countries will pay tariffs no higher than the nation that pays the lowest: called the “most favored nation” (MFN) principle. –An exception to this principle is allowed only if the lowest tariff rate is set at zero.

61. 10-61 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Preferential Trading Agreements (cont.) There are two types of preferential trading agreements in which tariff rates are set at or near zero: 1.A free trade area: an agreement that allows free trade among members, but each member can have its own trade policy towards non-member countries –An example is the North America Free Trade Agreement (NAFTA).

62. 10-62 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Preferential Trading Agreements (cont.) 2.A customs union: an agreement that allows free trade among members and requires a common external trade policy towards non-member countries. –An example is the European Union.

63. 10-63 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Preferential Trading Agreements (cont.) Are preferential trading agreements necessarily good for national welfare? No, it is possible that national welfare decreases under a preferential trading agreement. How? Rather than gaining tariff revenue from inexpensive imports from world markets, a country may import expensive products from member countries but not gain any tariff revenue.

64. 10-64 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Preferential Trading Agreements (cont.) Preferential trading agreements increase national welfare when new trade is created, but not when existing trade from the outside world is diverted to trade with member countries. Trade creation –occurs when high cost domestic production is replaced by low cost imports from other members. Trade diversion –occurs when low cost imports from non-members are diverted to high cost imports from member nations.

65. 10-65 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Trade Creation Three country: Britain($8)>French($6)>US($4) for wheat production. Suppose British Import tariff =$5. Suppose Britain and French forms a customs union. British consumer will buy products domestically since 8<9<11 without a customs union With a CU, then British consumer will purchase from his member country—French since 6<8. This is trade creation since Britain only needs to pay $6 to foreign country compared to its own initial cost $8.

66. 10-66 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Trade Diversion Three country: Britain($8)>French($6)>US($4) for wheat production. Suppose British Import tariff =$3. Suppose Britain and French forms a customs union. British consumer will buy products from U.S. since 7<8 without a customs union With a CU, then British consumer will purchase from his member country—French since 6<7. Trade diversion: (1) US wheat is really cheaper than French; (2) Import Tariffs revenue disappear.

67. 10-67 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Summary 1.The cases for free trade are that –It allows consumers and producers to allocate their resources freely and efficiently, without price distortions. –It may allow for economies of scale. –It increases competition and innovation. 2.The cases against free trade are that trade restrictions may allow –terms of trade gains –a government to address a market failure when better policies are not feasible

68. 10-68 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Summary (cont.) 3.Models of policy making for trade policy consider incentives to adopt popular policies as well as incentives to adopt unpopular policies if these policies are advocated by special interest groups that make political contributions. 4.Agricultural and clothing industries are the most protected industries in many countries.

69. 10-69 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effective Rate of Protection The effective rate of protection measures how much protection a tariff or other trade policy provides domestic producers. –It represents the change in value that an industry adds to the production process when trade policy changes. –The change in value that an industry provides depends on the change in prices when trade policies change. –Effective rates of protection often differ from tariff rates because tariffs affect sectors other than the protected sector, a fact which affects the prices and value added for the protected sector.

70. 10-70 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effective Rate of Protection (cont.) For example, suppose that an automobile sells on the world market for $8000, and the parts that made it are worth $6000. –The value added of the auto production is $8000-$6000 Suppose that a country puts a 25% tariff on imported autos so that domestic auto assembly firms can now charge up to $10000 instead of $8000. Now auto assembly will occur if the value added is up to $10000-$6000.

71. 10-71 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effective Rate of Protection (cont.) The effective rate of protection for domestic auto assembly firms is the change in value added: ($4000 - $2000)/$2000 = 100% In this case, the effective rate of protection is greater than the tariff rate.

72. 10-72 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Summary (cont.) 5.Multilateral negotiations of free trade may mobilize domestic political support for free trade, as well as make countries agree not to engage in a trade war. 6.The WTO and its predecessor have reduced tariffs substantially in the last 50 years, and the WTO has a dispute settlement procedure for trade disputes. 7.A preferential trading agreement is beneficial for a country if it creates new trade but is harmful if it diverts existing trade to higher cost alternatives.

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